Tuesday, November 3, 2009

When it comes to valuing the market should an investor start with his/her conclusions and then see if the market is in agreement (intrinsic value to market value stuff)? Or should an investor start with the market’s conclusion (in the form of its current price) and then attempt to identify what would have to be produced (in the form of projected future earnings) to justify the current price?

To accomplish the former, all one has to do is turn to the media and give a listen to the myriad of talking heads pontificating on what should be by starting with what they perceive is the message of the economy (or industry or company) and then debating their conclusions with that reached by the market.

To accomplish the latter, an investor would start with the message of the market and then seek to match it with an appropriate set of inputs (such as earnings, growth rates, and a discount factor) to determine what inputs would be necessary to match the current price. To do this, an investor would need a process by which the message of the market (in the form of its current price) is the start point from which the justification for that message must be acquired. Allow to illustrate how this could work.

The accompanying table* starts with the message of the market in the form of its current price. In this case, we use the S&P 500. That price level is then inserted into a simple, yet elegant valuation model that lists what earnings would be needed to justify current price levels. Next, an important part of the equation is the discount rate is used to bring the future cash flows (operating earnings) back to their present value**. Then, the current price is projected 12 months ahead. The final step is to divide an assumed P/E ratio into the forward market price to produce a calculated earnings level to justify that future price. What you have is what subscribers to my newsletter see every week – a market derived valuation model that seeks to identify what earnings and P/E might “match” the message of the market.

Each week I plug in the current price and then move the earnings numbers up or down to produce the market derived fair value that comes close to matching the current price. What this does is help me understand the expectations of the market that are built into its current price and the appropriate earnings necessary to justify that price. From this point, I can then decide if I am in agreement with the conclusions reached or beg to differ.

Investment Strategy Implications

One can obviously argue with several elements of the valuation model. For example, one might disagree with the time period used. Another might conclude that some of the assumed inputs, such as the discount rate (which is also the assumed required return for large cap stocks), are inappropriate. Then there is the use of a terminal value, the time period involved (just over 3 years hence), and its inputs (4% growth rate).

While valid, this is beside the point in the sense that by placing the market’s implied valuation via its current price into a valuation model that attempts to match the market’s implied value with the appropriate earnings necessary to justify the current market price enables an investor to challenge or accept the market’s conclusion (via its current price).

You can choose your metaphor - chicken or the egg, cart before the horse. Sometimes, focusing on the message of the market first enables one to hear more clearly.

*click image to enlarge**Note: The growth rate is calculated as a result of the earnings inputs and the discount factor. This is important as we want to keep the focus away from our opinion about what should occur and on what the market says will occur.

bio

President and Global Investment Strategist with Blue Marble Research and author of "Sectors and Styles" (Wiley 2006). Vinny is a leading investment strategist and asset manager. He appears regularly in the financial media (Bloomberg TV & Radio, Financial Times, Wall Street Journal, CNBC, Yahoo Finance, foxbusiness.com, BNN TV, New Delhi TV, CCTV - America, Barrons, Reuters) and is a frequent guest speaker at various major investment forums. Vinny also produces and conducts timely topical and educational programs with various CFA Societies and other groups, including the highly acclaimed "Market Forecast Series". Vinny is a past president of the New York Society of Security Analysts, a managing member of Adriatic Capital Partners, and a Nonresident Senior Fellow at the Information Technology and Innovation Foundation. Vinny attended The Juilliard School and New York University and earned his CFA charter in 1986.

Morning Call May 2007

Morning Call April 2007

CNBC "Kudlow & Co". March 2007

Morning Call March 2007

Kudlow & Co. February 2007

McDonald, Catalano, Luskin, and Burnett

Kudlow & Co. February 2007

Laffer, Catalano, and Froehlich

Kudlow & Co. January 2007

Malpass, Abrams, and Catalano

Disclaimer

The information found on this blog and in published reports. was prepared from data we believe to be reliable but is not guaranteed by us as being accurate and does not purport to be a complete statement or summary of available data. Such information and any views or opinions expressed herein are not to be considered as an offer to sell or a solicitation of an offer to buy securities of the sectors or styles covered on this blog and in published reports. Opinions expressed are subject to change without notice. Past results are no indication of future results.

Full disclosure: While neither Vincent Catalano nor any member of his family hold positions listed on this blog and in published reports, accounts managed by Blue Marble Research may hold such positions.

Some of the sectors, styles, regions, and countries mentioned are the recipients of trends and themes that might vary from those noted on this blog and in published reports.

Vincent Catalano certifies that all of the views expressed on this blog and in published reports accurately reflect his personal views regarding any and all of the subject securities or issuers.